hether you already own a business or are still planning to establish one, this handbook on basic accounting should prove useful to you as an entrepreneur. It will not only help you understand how your enterprise develops from a financial standpoint but also make you better equipped to make informed judgments and decisions in running it. Running a business can be intimidating particularly for startups, but the entrepreneur can make it less so by learning how to appreciate and use financial data in planning and controlling the business. The importance of accounting to any business, no matter how big or small, can thus be never underestimated. Without accounting, in fact, there is absolutely no way to find out—much less to precisely measure—whether or not your business is making any progress in achieving its strategic goals and profit objectives. The text for this handbook was written by ENTREPRENEUR contributor Henry Ong, who writes for the regular “Financial Adviser” section of our magazine. He is the president and chief operating officer of Business Sense Inc., a financial advisory and consulting firm that helps owners of small and medium sized companies create solid, reliable, and timely financial reporting systems for their businesses. His firm is the Philippine member-company of INPACT International, a global group of accounting firms with representation from over 60 countries around the world. To provide some light touches to what is oftentimes perceived as a rather intimidating if not really difficult subject, we asked our regular contributing illustrator, Frantz Arno Salvador, to do some illustrations for the handbook. The illustrations may not exactly make accounting easier, but they surely could make reading the handbook much less daunting—perhaps even inviting—to its readers. Whatever the case, there is no doubt in our mind that reading this accounting handbook can put you in a much better position to prepare your own roadmap for success for your entrepreneurial venture.







Its vision is to get Filipinos in the habit of buying and reading books and to do for books what Summit Media has done for magazines. quality. contemporary books. Summit Books is committed to providing the public with reasonably priced.table of contents 8 INTRODUCTION Why even small businesses need accounting 20 24 CHAPTER 4 Setting up an accounting system CHAPTER 5 The various financial reports 41 44 CHAPTER 10 Managing inventory CHAPTER 11 Managing payables 10 13 17 CHAPTER 1 Why accounting is crucial to your business CHAPTER 2 The first five basic accounting concepts CHAPTER 3 The other six basic accounting concepts 28 32 35 38 CHAPTER 6 Financial analysis CHAPTER 7 Budgeting CHAPTER 8 Cash flow management CHAPTER 9 Managing receivables Summit Books is the book publishing division under Summit Media. 7 6 ACCOUNTING 101 FOR SMALL BUSINESSES .

quit her job and partnered with her best friend in college. and a good way to know if the business is indeed making money is to keep reliable records of its income and expenses that can be reviewed regularly. Amie. they had been using only cost estimates instead of actual historical costs. Amie took charge of the operations side. They intensified their promotional efforts and raised their food standards. They didn’t have any idea either of how much income they were making monthly. They then opened a pizza restaurant in the university area along Katipunan Avenue in Quezon City. Jane did the marketing research for the business herself. They also began entertaining the idea that because they had not established a firm marketing budget. The reason is that they don’t have a sound accounting system. Despite having built good businesses. including choosing the location and determining its market potential. They also began to fear that something might be wrong with their inventory system. They started to suspect that they might have been pricing their products wrongly because most of the time. they sooner or later find themselves struggling with their finances. ■ WHY EVEN SMALL BUSINESSES NEED ACCOUNTING 9 . Indeed. While doing their expansion planning. Many owners of small businesses are. however. even after already paying the salaries of the restaurant staff and all their other operating expenses. Confident of her previous training in a reputable marketing firm. This record-keeping process is what we call accounting. They are unable to keep track of where all their funds have been going. they would have very little cash left in the bank. For entrepreneurs to succeed in a business. they were not generating enough cash to finance a new outlet. however. Jane. which they would then use to pay for supplies and purchases. they are unable to figure out if the business is making any money at all or actually losing—and by how much. they might have been overspending on their marketing expenditures. after disbursing their payroll. Just a few months after opening day. The only thing they knew was the amount of cash sales they were generating daily. The pizza restaurant proved to be an early success. The partners then began to wonder how come they were always short of cash when their business was supposed to be a cash cow. Jane and Amie continued to make improvements in the business. On the other hand. As its sales grew. And the strangest thing of all was that sometimes. in fact.introduction A 8 fter many years of working for a multinational company. they were so happy with the results of the business venture that they already started planning to expand it. they need to focus not only on operating it but on making money from it. like Jane and Amie. it had already developed many loyal customACCOUNTING 101 FOR SMALL BUSINESSES ers particularly from the university area. handling menu design and staff recruitment. a culinary graduate who used to work for a five-star hotel in Makati City. a successful marketing executive. the partners discovered something odd: Despite the fact that their sales had been growing steadily. and that perhaps some of their warehouse staff might not have been doing a truthful inventory of their supplies. worse.

and you can also evaluate how you had managed your cash flows and other assets. such as your balance sheet. You can do this by reading the different financial reports that you can gener10 ACCOUNTING 101 FOR SMALL BUSINESSES ate from your accounting records. and cash flow. income statement. A qualified accountant in your company can help you interpret the financial figures in the report correctly for evaluation and decision-making purposes. you will know how your business has performed financially during a particular period.chapter 1 ad 4 A ccounting is important to you and your business for many reasons. when you have an accounting system. To begin with. Also. you need to consult your accounting records regarding the net worth of your 11 . if you are planning to expand and would like to raise money by taking in new investors.

the revenue principle. however.000. expenses. and the conservatism principle. when ACCOUNTING 101 FOR SMALL BUSINESSES 13 12 ACCOUNTING 101 FOR SMALL BUSINESSES . and expenses. And to do the projections properly. The valuation that you arrive at will then become the basis of the selling price that you will offer to your prospective investors. Net worth is the residual capital left when you deduct all of your liabilities from your assets. In this particular case. your ownership will be diluted to 50 percent. the matching principle. Normally. you can use that as a starting point for valuing your business. the disclosure principle. Now. Indeed. you need to project your financial performance into the future. costs. when banks or investors would ask for your business plan. on the other hand. you can raise additional funding based on your net worth. the consistency principle. when you have a clear idea of how much your net worth is. Assume. that you found your net worth in the balance sheet to be P500. it is almost impossible for you to know how your business is doing. you need to have reliable historical financial data that you can only get from your financial statements. An income statement is simply a financial statement of a business showing the details of revenues. the objectivity principle. of course. the partners could have investigated it further to see if there was something wrong with their pricing or inventory system. you would be in a much better position to manage it properly and control your risks. Thus. It is accounting that will help you understand the financial dynamics of your business. For example. There may be instances. however. you can discover so much information about the behavior of your sales. you would need to borrow money from the bank instead. Even in this case. the accrual basis of accounting. costs. when you know how your business behaves. If you are unwilling to give up part ownership of your business. These basic accounting concepts are as follows: business entity. Jane and Amie could have discovered their problems earlier if they had an income statement that they could review regularly. A s you prepare to set up an accounting system for your company. you still would need to prepare your financial statements because your bankers will want to examine them to determine your financial standing. the materiality principle. ■ chapter 2 Using the income statement to discover problems I n the case study presented in the introductory chapter. the historical cost principle. if you raise P500. losses. you would not know the true net worth of your business. You can therefore see that without accounting.000. We will discuss the first five basic accounting concepts in this chapter. 1 Business Entity This is the most basic assumption in accounting. Without proper accounting of its assets and liabilities.000 in additional capitalization from new investors. in fact. And they could have fixed this inaccuracy by implementing proper costing procedures and internal controls. going concern. This is because the net worth of the business would expand to P1 million against your original equity contribution of P500. By reviewing past financial performance. They will also check how much assets you have in your business and how much cash flows your business is generating. Depending on how much equity in the business you are willing to sell. To make a business plan. Indeed. upon finding a significant variance between their budgeted gross profits and the actual result.chapter 1 business. it will be good to first know the 11 basic accountiing concepts behind the preparation of financial statements. Having an accounting system will help you see to that. banks will only lend you the amount they think you can afford to pay. understanding the factors behind the numbers will help you make your forecast better. for example. and profits for a given period.

As the owner of a business. Doing so will increase the expenses of your business. let’s change the situation. the market price of your property increases to P8 million. For example. your goal in the business is to eventually make money over time. the report will be more objective and fair. You checked The historical cost principle also applies to borrowed money N 2 Going Concern Because the company is separate from you. even if you have a bad year this year. Should you adjust the value of your price to reflect the current price at P8 million? Based on the cost principle. not at the cost of P150. And if you use the services of your company for your personal use. Assume.000 at the time of the transaction. how are you going to record this transaction? Under the revenue principle. The reason behind the use of the historical cost principle is to remove any potential bias that you may have when valuing assets. but you should also record a loss of P200.000 at the prevailing exchange rate of P40 to a $1. you need to pay for it just like an ordinary customer. you need to always look for- The historical cost principle also applies to liabilities when you borrow money in foreign currency. ward to recover the following year and make a profit eventually. and it shall continue to exist regardless of your personal situation. you should record that you are have paid o� your loan at its actual value of P800. you cannot treat the cash collection as sales because you have not delivered THE FIRST FIVE BASIC ACCOUNTING CONCEPTS 15 14 ACCOUNTING 101 FOR SMALL BUSINESSES . This is the amount that should appear in your balance sheet when your financial statement is prepared at the end of the month.000. it belongs to the company. Do you record the cash you received as sales? Under the revenue principle.000. not to you. For example. Following the concept of business entity. however. you should record sales during the month you sold the merchandise regardless of whether you have received cash or not. Several months later. not when cash is collected. If the car or the laptop computer that you are personally using was paid for by your company. This is the concept of going concern. Your business can be transferred to anyone in the future if you decide to sell your ownership. suppose you bought a property in Makati City for P5 million. Using the historical cost principle. This is because you have already completed the sales at that point. This is still the widely prevailing practice in many accounting systems. If you have made a cash advance from your company. Once recorded in the books. the ownership of assets must also be kept separate. 3 Historical Cost Principle The principle of historical cost simply states that all assets and services you acquired should be recorded at their actual cost at the time when the transaction occurred.000 which you believe is its real market value at the time you acquired it.000 but you were offered by your friend a discounted price of only P100.000. not P1.000. it is always expected to continue running. Suppose your client gave you cash as deposit today to make sure that you deliver the merchandise to him when it arrives next month. The argument for this practice is that when you use your actual cost.000 because of the currency conversion under a lower value for the peso. You would then record this liability at P800.000. Under the historical cost principle. It would be misleading if your personal expenses at home—expenses that have nothing to do with your business—are included in the income statement. Even if you are losing now. for example. you should record this acquisition at the actual cost of P100. it is assumed that your business will continue to operate indefinitely even if you are no longer its owner. that you want to buy secondhand office furniture for your new business and you happen to have a friend in the furniture business who could give you a big discount. because of the high demand for properties in the area. that the furniture you plan to buy was selling at P150. you borrowed US$20. By the time you are ready to pay your loan. Suppose that to finance your importation requirements. 4 Revenue Principle The revenue principle requires you to record sales when it is fulfilled and earned. it might happen that the peso had by then weakened to P50 to a $1. creating the impression that your business didn’t do well even if it did. This concept also provides that in accounting. the historical cost of the assets you have acquired shall remain in the records as long as the business exists. although the current trend in accounting standards is moving towards updating certain types of assets to current market price. if you sold merchandise to your client on credit and the latter promises to pay you next month. you don’t ask your company to pay for your personal credit cards or for your expenses at home. This is because you are your own entity—an entity that is separate from your business. the value of the property should remain at its historical price regardless of its fair market value at any time in the future. This principle is critical in accounting because it is necessary to account properly for all expenses related only to your business operations. you have the obligation to pay it back to your company in due time. Now. no matter how much in losses a business may have accumulated over the years.chapter 2 you are in business.

The same also applies to the franchise fee. When you accrue an expense. and other administrationrelated expenses that have no direct relation to sales but are necessary costs for running the business. there are expenses such as salaries of staff. namely the accrual basis of accounting. ■ chapter 3 5 Matching Principle Assume that you are planning to buy a franchise to open a restaurant. the sale transaction is not yet fulfilled. you need to depreciate the cost of construction over the useful life of the structure. you will wait for the billing to reach you—maybe two ACCOUNTING 101 FOR SMALL BUSINESSES 17 16 ACCOUNTING 101 FOR SMALL BUSINESSES . say. We will take up the other six basic accounting concepts in the next chapter. the materiality principle. you can depreciate the construction of your restaurant for. you found out that you still have food supplies le� in storage. If you disregard this principle and book all the food purchases to the cost of sales for that particular month. A good example is that in your business. Should you book the total food purchases during the month against your sales for that month? Under the matching principle.chapter 2 the merchandise yet. before issuing your check payment for these dues for. These expenses can therefore be reasonably charged against sales for the current period. With proper matching of cost and sales. the franchise fee you paid will be amortized over the number of years that the term agreement will be subsisting. you will be disciplined to regularly count your inventory—which. five years so that the monthly depreci- Applying the matching principle to food supplies usage S uppose you have already started your franchised food business and have made your initial purchase of food supplies from your franchiser. By the end of the month. you cannot book the franchise fee and cost of construction as expenses because there are no sales to match them with. what should be considered as the cost of sales should only be that portion of your food purchases that has been consumed and actually sold. the objectivity principle. Now the question is: Do you record these expenditures as expenses during the month even though you don’t have any sales yet? Under the matching principle. rentals. you assume that the expense occurred during a particular period even if no cash payment was actually made to cover that particular expense. but to properly recognize these expenses in your income statement. in particular. To match the expenses with sales properly. You paid P1 million for the franchise fee and spent another P10 million for the construction. say. This mismatch would increase your food cost and lower your income. and the conservatism principle. In this case. In practice. the month of July. For this example. and you would be misled into believing that the restaurant is not doing well. you are supposed to pay your monthly rental and association dues. The Accrual Basis of Accounting In business. The cash you received from your client should be treated as a liability instead because you need to return the money in case you fail to deliver the merchandise. you need to use the so-called accrual basis of accounting. that is. W 1 e will now discuss the other six basic concepts in accounting. however. however. by the way. The unused portion should be treated as inventory to be carried over to the following month for consumption. the disclosure principle. there would be a mismatch of cost and sales. will also serve as a deterrent against pilferage. the consistency principle. ation expense can be matched against sales for the month.

This is because financial data must be as accurate and as reliable as possible. ■ THE OTHER SIX BASIC ACCOUNTING CONCEPTS 19 3 2 Materiality Principle There are times when you don’t need to follow the matching principle strictly. The cost of the printer is very material in relation to the size of your foodcart business. would the materiality principle apply to the purchase? Yes. your accountant would normally suggest that you provide a certain percentage of your total receivables as uncollectible so you would not be so disappointed if any of your clients fails to pay you. For example. But when you are preparing your financial statements for your own use. all cash receipts are booked as sales and all cash payments are treated as expenses.000. However. You may be confident that you can collect all your receivables from clients. For example. When you looked at the notes to the financial statements. 4 Objectivity Principle In accounting. it is treated as a loss. The accrual basis of accounting. many small business owners find it simpler and easier to use the cash basis of accounting. all transactions must be supported by verifiable documents such as vouchers. say. a business has the discretion to choose which method of accounting practice it deems appropriate. so you can decide to charge the whole cost of the printer as an expense for the year. the small business owner only has to check how much cash is left in the cash register or bank account—if there is some. The disclosure principle normally is used when your financial statements are audited. However. but your accountant may not be as positive as you are. at the end of the day. P50 million. your management decided to change the depreciation period to ten years to cut the annual depreciation expense down to P50. however.chapter 3 weeks after the end of July. Indeed. Without this principle. should you record this as an asset and depreciate it for its useful life of three years? According to the materiality principle. you asked for and were presented its financial statements from last year. for the recording of the data would then be based largely on opinion. The following year. Other businesses use a modified method of the cash basis of accounting.500 in the first year instead of depreciating it for P1. accounting information would be generally subjective. you should be ready to set up the accounting system for your business. invoices. and selection of procedures. if you own a multimillion business and you acquire a printer for your office for P8. the documentation also serves as a good internal control mechanism.000. it is treated as a profit. where they use the accrual method only for certain portions of the recording process. the principle of consistency suggests that as much as possible. volve opinions. for your business to have comparable financial results.500. particularly if the amount to be recorded is not significant enough to affect the financial results of the business. Based on the income statement.700 in the next three years against your annual sales of. The reason for this is that they want to be fair and reasonable when making decisions that in- Allowances for bad debt You need to provide for uncollectibles so you are not disappointed if any of your clients fail to pay you. Is this practice allowable? . er it misleading for you to expense the whole P8. however. Under the consistency principle. When applying the materiality principle.000 in net income. you may not need to follow this principle strictly. Now that you know the 11 basic accounting concepts. The reason for this is that no one will consid18 ACCOUNTING 101 FOR SMALL BUSINESSES Disclosure Principle The preparation of a financial statement does not end with reports stated in numbers alone. Does the materiality principle apply to purchases of a food cart business? 6 I f you own a food cart business in which you invested P350.000 and you bought a printer for P8. which recognizes sales and expenses only when a cash transaction is made. you should accrue the July rental expense during the month of July even if you have not been billed for it yet. suppose you are planning to invest in a company. Following the principle of conservatism. and official receipts. is the method preferred by accounting standards for the preparation of financial statements. Will you still invest in the company after finding this out? Obviously not. this is disallowed unless inevitably necessary. if there is none. Thus. so you need to capitalize it as an asset and depreciate it accordingly. Now the question is: Are you going to record your July rental expense during the month of August? No. an explanation under the notes to financial statements should be made showing how the change will affect the overall results. accountants would always choose the method of accounting that results in a lower profit or a higher liability. Under the accrual method. Being conservative.500. thus giving you an extra P50. One good example of this accounting practice is making allowances for bad debts. Examples of this practice are the use of depreciation for fixed assets or not treating as outright expense certain inventory or assets acquired through cash purchase. and particularly if they are meant for management use only. the cost of the printer relative to the size of your business is immaterial. Conservatism Principle You need to understand that accountants are trained to be pessimistic when they perform their work. In this method. the company appeared to be profitable to you and you were on the verge of deciding to invest in it. it’s important to use your professional judgment in deciding whether an item is material— meaning significant—or not. probable that the company may end up paying huge damages should it lose in court. Should a change be implemented. such that the annual depreciation expense for your vehicles would be P100. assume that you have a depreciation policy that requires all acquired transportation vehicles be subject to a useful life of five years. you need to employ the same accounting procedure year after year. It helps create an audit trail that you would need when confirming certain transactions in the future. you found out that the company is under litigation and that it was 5 Consistency Principle Because every industry is unique. estimates. some financial facts not reflected in the numbers may be significant enough to influence the judgment of the user of the financial statement. For example. which helps simplify the matching of sales with expenses. As part of your due diligence. Aside from establishing the integrity of the information. It also requires notes and supplementary information that need to be disclosed so users can meaningfully appreciate the financial statement.

so you need to analyze each account and make the necessary corrections and adjustments. asset accounts start with the digit “1. it will become more 20 ACCOUNTING 101 FOR SMALL BUSINESSES and more difficult for you to remember all the details of your finances. first. So. It will save you the trouble of creating a new account for every transaction you make. posting these transactions on the ledger. a simple record-keeping system may suffice to monitor your collections and expenses. recording transactions in the book of accounts and. At the start of the month. SETTING UP AN ACCOUNTING SYSTEM 21 . At this point. it is important for you to first get familiar with the accounting cycle and with the books and ledgers needed to track and sustain that cycle. many organizations—even small businesses—use computerized accounting systems. as your business grows and the transactions that you deal with every day multiply. You will need to put up a better system for tracking your finances. Recording a transaction is simply to input in the book following a template header as it occurs. however.” “direct-mail expense. You may even be able to do all the bookkeeping yourself.” owner’s equity with “3. you need to review all of the accounts you have recorded and summarize them in a worksheet that you can use to create a trial balance. Perhaps you may have to hire a qualified accountant or even invest in computerized accounting software. In this case.” The list can go on and on depending on the number of payments you have made for particular transactions of this type.” and A chart of accounts simplifies accounting for you Assume that you want to record your payments for brochures. By the end of the month. For example. A chart of accounts is simply a list of all the accounts in your general ledger. However. Whichever of these you decide to do. second. Since a spreadsheet program automatically generates a trial balance. that account would be “marketing expense. Only after you have done all the adjusting entries should you prepare your financial statements. and promotional items to three di�erent suppliers. This is how accounting is done manually. The first thing to do in designing your accounting system is to set up your chart of accounts.” sales with “4. though.chapter 4 Every accounting system deals with books of account and ledgers.” liabilities with “2. the two major accounting activities you need to perform are. and that list will serve as your guide as to which account to use when recording a specific transaction.” W hen you are just starting your business. of course. however. you only need to record all transactions for similar activities under just one type of account. advertising placements. you will need to set up an accounting system for your business. If you can’t afford to get an accounting software package off the shelf. you don’t even have to prepare one to produce your financial statements. you will sometimes find accounting errors or incomplete capture of transactions. direct mailers. you would be recording each transaction by creating account titles such as “brochure expense.” “advertising expense. If you have a chart of accounts. you can at least use a simple spreadsheet program to automate the computations and posting of balances to the ledger. posting means recording all similar transactions in a ledger that summarizes and totals them at the end of the month. The design of a chart of accounts involves assigning of numbers to particular types of accounts for easy reference. making your financial statements very long and unwieldy. before planning to set up an accounting system.” and “promotion expense. Nowadays. If you don’t have a chart of accounts.

As this relates to accounts payable. then posting them to the accounts receivable subsidiary ledger that contains the supporting details for each individual customer. Cash disbursement book This book records all cash payments made by the business for its accounts payable and other business expenses.2 Your system must be compatible with your business operations and organizational structure. At the end of the month. the specific collection from that customer entered in the cash receipts should also be posted to that customer’s subsidiary ledger in the accounts receivable ledger. or as a cash transaction. When you have set up a chart of accounts. purchases book. But how do you identify which customer owes you how much at any time? You can do this by getting the specific entries for a particular customer from the sales book. the system must help you prevent unauthorized payments or the� from cash collections. Every time you record cash collections. The mechanics for posting to the general ledger and subsidiary ledger of the accounts payable are the same as those of sales and cash receipts book. cash receipts book. Your current system should be able to adapt to possible changes in the business . Do the benefits of buying an o�-theshelf computerized system outweigh the cost? Are you better o� simplifying your accounting with a manual system rather than investing in so�ware packages given your current business setup? 22 ACCOUNTING 101 FOR SMALL BUSINESSES SETTING UP AN ACCOUNTING SYSTEM 23 . Cash receipts book This book is used to record all cash receipt transactions. To update the account of individual customers. you can start planning how to classify similar transactions for efficient recording. cash disbursement book. Your business may expand in few years’ time with new products and services. there are accounting entries that can’t be considered as sales. In particular. supplies. When you add up all the entries in the sales book. This will enable you to summarize total sales to date and at the same time monitor your customer accounts. but no matter how sophisticated or simple you want your system to be.1 Your system must enable you to exert control over transactions. preparation of subsidiary ledgers is required for all suppliers with credit terms to help you stay current with payments and balances.chapter 4 Another advantage of having a chart of accounts is that it also serves as an internal control mechanism. Basically. NO. Everything that you purchase from a supplier needs to be recorded under this book. there are five books of account you need to keep: the sales book. Once a chart of accounts is implemented. What is the use of acquiring expensive accounting so�ware when you can only use 20 percent of its functions? NO. ■ Four musts when designing your accounting system Every accounting system is unique to a business. you also need to identify whether it is from accounts receivable or from cash sales. General journal For transactions that you can’t classify under any of the four journals above. Sales book All of your sales should be recorded under the sales book. you will get the total amount of credit sales.3 Your system must be flexible enough to allow you to upgrade it without doing a complete overhaul. you need to summarize the total amount of accounts receivable collected and post it as a deduction to the general ledger account of accounts receivable. as a purchase. and other assets on account. Typical examples are depreciation expense and an accrual entry for electricity expense that has not been billed yet. which you can then post to the general ledger under accounts receivable. the purchases book works the other way around by accounting for all purchases of inventory.4 Always do a cost-benefit analysis when designing an accounting system. no one in your company can introduce a new account or make any changes in it without your approval as the owner. Indeed. Purchases book Although similar in form to the sales book. there are four very important things you need to remember when designing it: NO. and the general journal. you can post them under the general journal book. NO.

you will see how much sales your business has generated and the corresponding costs and expenses it incurred over a specific time period. the report has to be generated on a regular basis so it can help you effectively evaluate the financial performance of your company. and where it is now. the balance sheet. Your ownership in the business is represented by equity. you need to formalize the reports according to the standard forms. when filing your financial statements with such regulatory agencies as the Securities and Exchange Commission or the Bureau of Internal Revenue.000 120. The income statement follows a simple format that shows you the amount of sales of your business minus its expenses to yield the net profit or loss.000 25.000 400.260 THE VARIOUS FINANCIAL REPORTS 25 . To better appreciate the details of an income statement in expanded format. In the income statement.900 2.400 63. The balance sheet is your primary source of information about your company’s financial position.000 9. which is the amount left after you deduct liabilities from total assets. They come in many forms depending on how you want to customize it. Just like your creditors who expect to be repaid at some future date and earn interest on their loans they have extended to you. you don’t necessarily own all the assets of the business. where it went. you can simply generate your own report from your company’s accounting system.500 5.000 7. In any case.chapter 5 Income statement This is your most important source of information about the profitability of your business.140 117.000 (2. you as owner also ABC Corporation Income Statement For the Year Ended December 31. Financial statements simply tell you where your money came from. The balance sheet follows a simple format that shows how the assets of a business are financed by liabilities and equity. The presence of liabilities in the business simply tells you that your supplier or your bank creditor technically owns a piece of your business and that they could actually force you to give them a share of it if you don’t pay them. Philhealth and Pag Ibig Rental Expense Marketing Expense Utilities Expense Insurance Expense Depreciation Expense Operating Income Other Income and Expenses Interest Income Interest Expense Income Before Tax Less: Income Tax Net Income 850.500) 180. 217.000 5. and the cash flow statement.100 182. For your own consumption. it only means that even if you control it. however.000 450. The three types of financial reports that you need to prepare regularly are the income statement. This relationship is expressed by the famous accounting equation below: Assets = Liabilities + Equity When we say a portion of your business is financed by liabilities. However.600 35.500 I f you can analyze the debits and credits of your own checking account. then you should be able to read financial statements. consider the financial statement of a trading company that we will call the ABC Corporation. You may even have to get your financial statements audited by an 24 ACCOUNTING 101 FOR SMALL BUSINESSES independent auditing firm not only to ensure that the figures are correct but also that they are presented according to the International Financial Reporting Standards.000 15. This is where you get a snapshot of your company’s asset holdings and liabilities. 2008 Sales Less: Cost of Goods Sold Gross Profit Less: Operating Expenses Salaries Expense SSS.

that increase would also require a corresponding deduction from your cash balance. rental income is not part of your regular operations. but… I f you are in the food retail business and the business happens to own a couple of real estate investments for rental. your business is in essence lending cash to your customer to buy products from you.260 1. December 2008 (162. your main business may incur an operating loss but still manage to report a net income in the end.000 Total Assets 2. and financing.650 350.000 Net (decrease)/increase in cash Cash balance. 2008 Assets Current Assets: Cash Accounts Receivable Inventory Others Fixed Assets: Leasehold Improvement O�ce Furniture Equipment Intangible Assets Franchise Fee Liabilities 350.000) (63.150) (56. you must keep in mind that you need to evaluate your business in terms of three types of activities: operating.150) (318. should you consider the rental income part of your operations? You shouldn’t. Indeed.000 250.000 125.000 (306.000 450. Since your company’s core business is retailing.000 (250. when you sell real estate owned by your business. it should be treated as “Other Income” instead. This is if the nonrecurring income from the sale of the real estate is higher than your operating losses.650) 512.000) 150.237.000 150.000. However.chapter 5 ABC Corporation Balance Sheet December 31.000 120. Look at the balance sheet of ABC Corporation (table on this page). In the balance sheet. The explanation for the cash movements in your business—where the cash came from and how it was spent—can actually be found in the cash flow statement.000) (120.000 ABC Corporation Statement of Cash Flows Year Ended December 31.260 2. However.000 require a certain rate of return on your investment.000) 50.000 750.000 261.500 (130.500 9. the amount of total assets must be equal to the sum of the liabilities and equity. while all of the liabilities and equity are on the right 26 ACCOUNTING 101 FOR SMALL BUSINESSES side. For example.000 117.975.000 150.740 1.000) (5.000) (50. 2008 Cash Flows from Operating Activities Receipts Collection from customers Interest received Dividends received Total cash receipts Payments To suppliers To employees For interest expense For income tax Total cash payments Net cash outflows from operating activities Cash Flows from Investing Activities Acquisition of fixed assets Proceeds from sale of fixed assets Net cash outflows from investing activities Cash Flows from Financing Activities Proceeds from issuance of capital stock Proceeds from bank loans Payment of bank loans Payment of Dividends Net cash outflows from financing activities 350.857.000 1. ■ THE VARIOUS FINANCIAL REPORTS 27 . This is because by selling merchandise on credit.650) 650. investing. You can see that all of the assets owned by the company are listed at the left side of the balance sheet. December 2007 Cash balance. doing the cash flow statement is actually not a very easy task.975.000 250. because the preparation of a cash flow statement involves conversion of certain financial data from the accrual basis of accounting to cash basis.000 150. you would be rewarded by an increase in the value of your equity if you decide to sell your ownership shares someday.000 (156. 200.117.000) Real-estate income isn’t part of a food retailer’s regular operations.000 Current Liabilities Accounts Payable Salaries Payable Others Long Term Liabilities Bank Loan Payable Total Equity Paid Up Capital Net Income Total Total Liabilities and Equity 1. when you record an increase in accounts receivable from additional sales.740 250.000 2. The cash flow statement can actually be created without requiring new data because the needed information can be derived from your balance sheet and income statement. When you read a cash flow statement.

data that you can find in the financial statements may provide some interesting signals that you can act on. you can analyze your financial ratios according to three measures: liquidity. By just looking at this ratio. such as accounts payable and accruals.000. For example. accounts receivable of P100. LET’S START WITH LIQUIDITY RATIOS Current ratio You can measure the ability of your business to pay its short-term suppliers through the current ratio. Leverage ratios. the higher the current ratio you get. Generally. This means that you are financially very liquid. you could have made it earn more by investing it in another business or in a high-interest-bearing money-market fund.000 guarantee that you are managing your resources efficiently. and inventory in your current assets. from your balance sheet. you have P1. Your current ratio is therefore 1. But a closer look reveals that its most liquid assets—the cash and accounts receivable—amount to only P150.chapter 6 ness results? A common way to do it is by ratio analysis. we add the total cash and receivables—P50.000. As a rule. To track your financial position without getting overwhelmed with a welter of details.000. the better for you because it means you have a stronger financial position. and inventory. Through comparative analysis. For example.000—to come up with the sum of P150. One way of taking control is. For example. current assets are those assets that your business expects to convert to cash within the year. however. which tends to be misleading when the current assets account is bloated by excessive inventory. and inventory of P350. This may be due to uncontrolled expenses or to the rapid rise of your inventory and accounts receivable levels without your realizing it.000. Indeed. the total of cash and receivables must at least equal the total current liabilities. in fact.000. we also need to analyze the extent to which the business is relying on other people’s money to fiFINANCIAL ANALYSIS 29 E CURRENT CURRENT ASSETS = RATIO CURRENTS LIABILITIES your company may soon be heading for trouble if your profit margins keep on falling for successive months. such as cash. Acid test ratio As a rule under the acid test ratio. Then. which is the extraction of a meaningful relationship between any two numbers in the financial statement. When we apply the acid test ratio.000 plus P100. it is preferable to achieve a current ratio of 2:1 or higher. you may have accumulated so much cash in your bank account. This is a more conservative measure of liquidity of a business than the current ratio. on the other hand. which is far below the total current liabilities of P250. However. How do you go about controlling your financials through the analysis of the company’s busiand current liabilities of P100. of course. but it also shows that you may not be maximizing your opportunities to earn. Current liabilities. assume that your business has cash of P50. After evaluating liquidity. it would appear that the business meets the liquidity criteria and can therefore be considered as liquid. Instead of just allowing your excess cash to lie fallow in the bank. accounts receivable. are those financial obligations that you expect to pay within the year. For example. you find that you have current assets of P150. This means that the business is far from being liquid as the current ratio suggests. thus bringing your current ratio to a high level.000. you get total current assets of P500. which is computed by dividing current assets by current liabilities. you get a current ratio of 2:1.5:1. As previously defined in Chapter 6.000.000. When you add this up. it is no ntrepreneurs need to develop some sense of control in their financials to keep their businesses durable and healthy. these impending problems could seriously affect your productivity and even threaten your company’s survival. receivables.000. by analyzing the financial information generated by the company’s accounting system.000 as compared to current liabilities of P250. you may not be aware that 28 ACCOUNTING 101 FOR SMALL BUSINESSES . This looks all right initially because you have more assets than liabilities.00 worth of payables. meaning that for every P1.50 worth of cash. Ratio analysis is. a good way of identifying potential problem areas and opportunities within the company. leverage. if no management action is taken. and profitability. when you compare their sum with the current liabilities of P250.

Also. Assume that total borrowings of the company is P300. you need to interpret them properly and discover which of the ratios is most crucial to your particular business.00 worth of your personal capital. you add back the depreciation and amortization expenses amounting to P350. In the restaurant business. The net profit margin is one of the ratios that you can use for this purpose. As important to you as an entrepreneur. however. it means that something is wrong with your operations and you need to investigate and correct the situation. the company’s market share. Yours may be a unique industry. which you will use to divide net profit to compute for your ROE. financial ratios as a tool for financial analysis can be very helpful indeed. As a rule. however.000 and your sales is P150. If your return on equity exceeds RETURN NET PROFIT = ON EQUITY TOTAL ASSETS-LIABILITIES 30 ACCOUNTING 101 FOR SMALL BUSINESSES FINANCIAL ANALYSIS 31 . This means that for every P3. which�comes out at�20 percent. One way to appreciate this percentage is to compare it with the prevailing money-market interest rate.000. you can use it to evaluate your investment. which means not exceeding a debt ratio of 50 percent.000 out of total sales of P1 million. You need to remember that it may not be easy to compare your financial ratios accurately with other companies because they may be using di�erent accounting methods or di�erent accounting periods. You then divide total debt by total equity. If your return on equity goes below market rate.000 in the total operating expenses. you can also compute for your debt to equity ratio. you might not have been managing your investment efficiently. the most critical ratio is the food cost percentage. the return on investment refers to the total profit or loss�made by the business relative to the assets invested.000 in total equity. For example.�Upon closer examination using the income statement. and the competitive life cycle of the company’s products—there is no fixed rule as to how much profit margin a business should earn. however. Return on profit or assets This other profitability ratio measures the rate of return. it means that you have created value for your business.000 to the operating income to get total cash earnings of P400. EBITDA This term stands for Earnings Before Interest. which is computed by dividing the cost of food by the food sales and multiplying the quotient by 100. but it does have limitations. you can focus on realizing the ideal ratio that will enable you to achieve your financial objectives. For example. When you want to evaluate business performance. This way. you generally would want to find out if your profits are increasing and how they compare with those of your competitors in the industry. For example.000. This rate is commonly known as ROI or return on investment. If you have repaid all your borrowings. net profit is P50. When you know your rate of return. First. ■ The limitations of comparative financial analysis It’s definitely useful to do financial analysis for your business. For decision making purposes. Depreciation and Amortization.�It is often understood as “cash earnings” because it only considers actual cash expenses without non-cash items such as depreciation and amortization expenses. it could mean that even if the business is making money. Alternatively. you derive your equity by subtracting total debt from your total assets to give you P250. Strictly speaking. it means that you are managing your resources efficiently. It is calculated by dividing net profit with sales. You can also�evaluate the capability of your business to repay�interest expenses or recover your fixed capital investments by looking at monthly or annual cash earnings.000 and the total assets are worth P500. in particular. the higher the risk and the greater the probability of a huge loss if sales projections don’t turn out the way the business expects. your net profit margin is 33 percent.�When you know your EBITDA. you simply remove liabilities from total assets so you use only your invested capital�as the main divisor. which measures the percentage of debt in relation to total assets. then your return on investment will be the same as your return on equity. however. If your net profit margin is increasing. If it is declining. you�notice that the reason for such�low�income was due to huge depreciation expense of P250. This percentage is so sensitive that very strict controls need to be implemented to ensure proper releases of food inventory and supplies. Net profit margin Because profit depends on a lot of factors—among them the nature of the business.000 and amortization expense of P100. you�will be able to compare the profitability of your company against�its nearest competitors on “apples-to-apples” basis. your debt ratio would be 75 percent.�you have an operating income before�interest expense and income tax of P50. An example of the leverage ratio is the debt ratio. Tax.00 you borrowed to finance the business. so you may need to also develop your own critical ratio to allow you to manage your business more effectively and efficiently. simply divide net profit by total assets to get ROI rate of 10 percent. you should not borrow more than half of your total assets. your business may be following the calendar year from January 1 to December 31. To compute for return on investment. if your net income is P50.chapter 6 nance its investments and operations. which yields a ratio of 3:1. which of course would make direct financial comparison between that company and yours extremely di�cult. your equity becomes P200. but the business you are comparing it with may be following a fiscal year that starts on July 1 and ends on June 30 the following year. You use EBITDA analysis when you need to know the earnings�capacity of the business. To compute for EBITDA. you have put in P1.000. For example. The higher the leverage ratio. if your total debt (including those you had borrowed from the bank to finance your business) is P750. The degree of financial risk you are taking when taking debt to help finance the business can be measured by the so-called leverage ratios. But if the bank rate.000. which can be financed by both borrowings and equity.�For example. This figure becomes more meaningful when compared to that of the previous period.000 and your total assets is P1million. RETURN NET PROFIT = ON INVESTMENT TOTAL ASSETS you compute for return on equity or ROE.000. your competitor may also be engaged in other product lines that you don’t have. which indicates the percentage of money gained or lost relative to the invesment you put in the business. But these ratios alone are not enough.

One quick way to create a budget is to look at your financials for the previous year and adjust them by a certain percentage to come up with your budget for the succeeding year. but those changes can be either positive or negative. this is much better than the counterproductive short-term corrective measure of punishing them each time they fall short of that budget. Your team should Budgets coupled with incentives motivate people to do their best Indeed. In any case. If those sales targets are reasonable.000 but your actual spending reached P150. the participation of the employees in the budgeting process could help ensure the acceptance of those goals and vision and eliminate any pockets of resistance. Thus. This method is good for a start. for example. you might discover that your food costs have overshot your budget because the staff has not been controlling your inventory properly. that it was due to overtime costs that were not fully anticipated. it helps you manage your risks and identify opportunities that may come along.chapter 7 For example. For example.000.000 ACTUAL SALARY = P150. Assume. For example. and such assumptions can sometimes prove very di�cult to make.000. it is important that the performance evaluation be done in a positive manner. but the process should not stop here. variances will always occur between budgeted amounts and actual results. Perhaps you may even consider rewarding your employees every time they meet your budget. budgeting should be part of a continuing planning process that constantly monitors and measures all of the business functions. You then can look for the reason for the variance of P50. they will work extra hard so they can get their bonus. that your budgeted salary costs for the previous year totaled P100. when your staff is not to blame for the variances. of course. though. Even if you may not get it right the first time. This is 32 ACCOUNTING 101 FOR SMALL BUSINESSES because budgeting is a very important part of goalsetting for the business. is proving unproductive to the business. Once a budget is approved. You therefore need to trace the causes of these variances so you can correct employee behavior that it to increase by 25 percent. BUDGETED SALARY = P100. you could set your budget for this year at P250. 10 percent in computing your net income target. it becomes a standard against which performance can be measured. if your sales last year was P200. though. Let’s assume that you have an incentive program that o�ers your salespeople a bonus each time they achieve their sales targets. if those sales targets are too high. As the budget becomes the basis for controlling all business activities. Indeed. It can also effectively impart the entrepreneur’s business goals and vision to the employees and provide them with a vehicle for voicing their concerns and sentiments about those goals and vision. These variances may have been caused partially by your company’s lack of internal control. say. your salespeople would obviously be positively motivated. Whatever the outcome of the investigation. There may be times. Hence. You should therefore make sure that it is immediately implemented as soon as it is finalized. However. budgeting can change certain behaviors. so they might just give up without even trying. Because budgeting is based on assumptions regarding how sales and expenses will change in response to changes in your business. they might think of those sales targets as impossible to achieve in the first place. it establishes the parameters within which you and your employees should function. your salespeople might get discouraged. It’s definitely not an activity to be done only for a few days and then totally ignored afterwards. you might find out. for instance. You can then adjust last year’s operating expenses upward by. the outcome of this process can provide you with valuable information for planning the next budget cycle and for keeping your business on track.000 VARIANCE = OVERTIME PAY B udgeting is more than just putting numbers into your spreadsheet after you have made your business plan.000 and you expect BUDGETING 33 . Having a budget allows you to specify which resources to use in order to achieve your business goals.000. A good budgeting system is one that gets everyone in the organization involved in the budgeting process—from the business owner and key people all the way down to the employees. you can use the budget to analyze your financial performance by comparing budgeted to actual results. you can improve your chances through continuous planning. Of course. The process can eliminate a lot of confusion and misunderstanding in the organization. setting targets requires you to make sure that you have realistic assumptions.

If you are always unable to collect your accounts receivable on time. For this reason. the probability is high that you would forget the assumptions you had made several months a�er finalizing the budget. you need to clearly understand the various factors that affect your cash flow. and the inputs resulting from that review can then be incorporated in the final budget. Changes in technology and government policy may also affect the way you run your business in the future. This way. you won’t be able to generate enough funds to pay for your operating expenses. there is no absolute accuracy. Now that you know how a good budgeting system works. So. thoroughly review the budget to find new ideas and creative ways of controlling your costs. The lifeblood of any business is its cash flow. For example. Based on experience. and selling expenses in accordance to your sales growth. the business is like a person drained of blood. salaries. you may assume that it would increase by 15 percent because you expect to spend more in commission expense and marketing. a direct labor budget. cost of goods sold. overhead. managing cash flow is a critical area in finance. managing cash flow always starts with making sales foreACCOUNTING 101 FOR SMALL BUSINESSES 35 . For example. the process is a little more tedious because you need to prepare additional budgets such as a production budget. only plain educated guesswork. a direct materials budget. you may need to source financing to bridge your cash shortfalls. you will be in financial distress and may even need to close shop. This is because the cash that goes in and out of your company is actually what determines your financial position. if you are in cash deficit. Thus. Sooner than you think. ■ chapter 8 Always put your budget assumptions in writing! Making assumptions about the future is a critical part of the budgeting process. But always keep in mind that in budgeting. You also need to consider the economic factors that may affect your business.chapter 7 estimate that your salaries expense budget will increase by only 2 percent even if your sales grows by 20 percent because you assume that any increase would only be minimal and would likely only come from overtime costs. you have provided yourself with a map that shows you how far your company has grown and how much further you would want it to grow. you should use budgeting more as a guide rather than as a control tool. it is wise to always put your assumptions in writing. If you are in cash surplus. During this process. Normally. you may 34 ACCOUNTING 101 FOR SMALL BUSINESSES S uccessful entrepreneurs with a good business concept may consistently register record sales and profits. entrepreneurs should similarly monitor their cash flow “stats” to develop an effective financial strategy. So. but they can still go bankrupt because of cash flow problems. These budgets are critical as these will affect the costing of your product. In businesses where projected sales is the source of the cash receipts budget. after making your sales forecast. on the other hand. Indeed. one that can spell the difference between the success and failure of a business. Higher inflation resulting from a weakening peso and higher interest rates may increase your operating expenses. to come up with a good assumption. You may also want to benchmark against your competitors to get some ideas. you can possibly invest the excess money in short-term investments. If you want to have a more detailed plan. This will also help you when you need to modify certain assumptions due to changes in the macroeconomic climate. you may have to do research on economic trends and assess how these will affect your forecast. it is important that you apply your personal knowledge and judgment in making estimates about the behavioral relationship of your costs with sales. Indeed. Rising competition in your industry may affect your sales and your ability to price higher. If you are in the manufacturing business. you will need the help of your production staff to prepare these budgets because the process of determining the cost behavior of these items may be dependent on the technology of your manufacturing equipment as well as on the setup of the manufacturing facility. you can always refer to the document when evaluating variances or when explaining your budget to your investors. As for selling expenses. just like smart basketball coaches who develop a winning strategy by reviewing their strengths and weaknesses through the “stats” of their teams. you can create separate budgets for purchases. you can develop your final budget along with supplemental schedules for operating items. for you to do good forecasts and effectively deal with changes in your cash position. and a manufacturing overhead budget. Without it.

you simply use the first month’s cash ending balance as the cash beginning balance for the next month. Once the template has been made in consultation with him or her. monthly sales usually peaks during the holiday season but immediately weakens during the following three months until it picks up again during the summer season. As business events unfold during the year. seasonality plays a key role in cash flow forecasting because it affects the sales pattern for each type of business. you may simply get their historical monthly averages during the previous year and project those averages to the current year. you can therea�er simply put the figures in the template on your own to easily come up with your forecasts. fashion garments. So. you will need to project how much inventory has to be purchased monthly to meet your sales forecast. make sure to consider in your cash forecast for a particular month only the portion of the receivable that you expect to collect on that month. you will need to establish a realistic basis for estimating the next month’s sales figure. you need to apply a 30 percent downward adjustment on your preceding December sales. You need to consider all of these factors when planning your cash flows. you learn that you have lost some significant customer accounts to your competitors. You will then be able to come up with your cash ending balance for the current month. ■ Sources of cash collections Your sources of cash collections will either be recurring or nonrecurring: • Recurring items are those that come from operations. 36 ACCOUNTING 101 FOR SMALL BUSINESSES When doing a forecast for your cash flow. you can then project your payments to your suppliers based on your credit terms. but it ends with a projected cash ending balance. • Nonrecurring items are those that come from investment and financing. candy shops. After that. such as capital advances from your business partners or proceeds from bank loans and other items of similar nature. Add to this balance your cash receipts during the month. But when cash sales are not sufficient to cover your fixed expenses. if you need to pay your supplier after 60 days. Once you have your forecast showing the total cash receipts and cash disbursements projected for each month of the year. You may have to lower your sales forecast in the middle of the year when. For example. which you can identify from your accounting ledger. but there are also customers who always delay and make it difficult for you to collect. This is particularly the case if your business doesn’t provide long-term credit to customers. there won’t be so many activities during December. Or you may have to adjust your expenses upward in the last quarter of the year because of the additional sales staff that you expect to hire during the Christmas holidays. you need to know the pattern of cash collections and to also know your customers. you can get the difference between them to determine your net cash flow. To accurately forecast your cash flow. You need to follow this procedure for the rest of the months of the year. To complete a 12-month forecast. always remember that having a cash flow forecast can bring a sense of order and well-being not only to your business but also to yourself as an entrepreneur. For this. CASH FLOW MANAGEMENT 37 . service centers. When you understand the concept of cash flow and learn how to measure it accurately. If you are in the accounting business. restaurants. electricity. with which you can start doing your projection of cash receipts and disbursement for that month. when you forecast for the second month. For instance. If you are in the wholesale business. For your cash disbursements. Get expert advice when making your initial cash flow forecast It’s a good idea to ask your business advisor or accountant for guidance when you are planning to construct your initial cash flow forecast. The typical credit you can give to customers ranges from 30 days to over 90 days depending on your willingness to invest in accounts receivable and on the level of competition in your industry. supplies. it would be good to assume a seasonal pattern. The cash projection can be made simply by assuming the amount of sales you expect to generate for a particular period. you need to constantly modify your cash flow forecasts. ice cream parlors. your business would be likely to provide credit to customers. In any case.chapter 8 casts. A positive net cash flow indicates that you have generated additional cash to your cash balance. in contrast. If you have historical sales data from the previous year. a negative net cash flow means you have overspent during the month by that amount. Good examples are businesses like food-cart franchises. On that basis. These adjustments are necessary to make your cash-flow planning accurate and up-to-date. assume that your sales in December last year was P500. The resulting figure will be your net cash flow for the month in question. This will also be your starting cash balance for the next month. then by aligning your expenses accordingly to estimate your cash flow. say. you may want to use the following template: Start with your actual cash ending balance from the previous month. and similar activities where sales transactions are made in cash or by credit card. For example. A point may even be reached when you need to consider certain accounts as bad because it is no longer possible to collect them. The first month in the forecast always uses the actual cash balance in the beginning of the month. of course.000 and you noticed that there was a drop of 30 percent the following January. with some minor adjustments if need be. and salaries. you can improve the performance of your business and make it more competitive. in the fashion garment business. Understanding your business is thus very important in making realistic estimates for your cash flow planning. when you make your sales forecast for January in the succeeding year. but your business would start to pick up during the first quarter of the following year because of the tax season. Then. There are customers who always pay on time. For some expense items like rental. If you sell on credit terms or installment basis. Another major disbursement item is your payments to suppliers. you have to input the amount you expect to pay for that particular month. you will need to project your various expense categories. cash flow problems can occur. such as sales to customers. you need to do the same process for the remaining months of the year. For cash receipts. beauty salons. Indeed. which then has to be deducted from your starting cash balance for the next month. deduct your cash disbursement from it during the current month.

Your long cash-to-cash cycle problems could be due to any or all of these situations: (a) most of your accounts receivable have long been overdue. But precisely how do you start determining your cash-to-cash cycle? Let’s first look at each component—starting with accounts receivable—to see how computing your average collection period can help your business. You can do this by understanding MANAGING RECEIVABLES 39 . say monthly or quarterly. Di�cult customers who always pay late are actually borrowing your money interest-free. you can easily analyze which part of the business you need to improve. For example. every time your customers fail to pay on the due date. you incur costs that may not be obvious to you. you could have earned extra income by placing your collection proceeds in the money market. you need to first compute your receivables turnover by dividing total Don’t let your account receivables bleed out your cash flows! If you always have a hard time collecting receivables from your customers. the higher the risk that you may run out of cash. When this happens. the analysis will enable you to concentrate on improving your accounts receivable collection as well as your inventory and payable management. you have determined your cash-to-cash cycle to be 180 days. Or the cost may be the actual interest expense you pay for money you borrow from the bank to support your working capital requirements each time you can’t collect your receivables. One good indicator of the credit profile of your customers is your average collection period. After that. it is highly probable that a significant portion of your outstanding accounts receivable is bleeding out your cash flows. which means that you are either unable to sell your inventory or collect your receivables from clients. of course. You can fix these situations by coming up with the necessary policy changes with respect to your accounts receivables.chapter 9 the cash-to-cash cycle of your business. Specifically. You can discover so many things about your business when you make cash-to-cash cycle analysis part of your cash management strategy. These costs could be in the form of opportunities that you have missed. the more you become successful in your business. This cycle is the average collection period plus average inventory age less the average payable period. One way to finance occasional cash shortages brought about by an increase in business activity is. the level of their inventory and receivables also increases. D o you fear that you will wake up one day to find out that you have to close down your business because you don’t have enough cash to pay for all of your financial obligations? And why is it that sometimes. Indeed. and (c) you may be paying your suppliers too soon. assume that based on your last months’ results. you should monitor the trend of your cash-to-cash cycle during the following period to see if there is any improvement. For example. The cash-to-cash cycle is simply the number of days it takes you to collect your cash back after investing it in inventory and receivables. When you have this information. You can then investigate which component of the cycle is causing this and seek solutions on how to improve it by reducing the number of days of the cycle. You can calculate your cash-to-cash cycle from your financial statements on a regular basis. The longer you wait to get your money back. to manage your cash more effectively. To figure this out. (b) you have so many slow-moving items in your inventory that couldn’t be unloaded in the market. the entrepreneur simply has no choice but to put in more cash into the business to finance its growth. the higher the probability that you would go bankrupt when you stumble into a serious cash crisis? 38 ACCOUNTING 101 FOR SMALL BUSINESSES This is because many entrepreneurs don’t understand that when their sales increases. thus minimizing your risk of experiencing cash flow problems.

you should focus on your small accounts receivables because they have a higher probability of getting collected.5 million. You can then prioritize your collection efforts accordingly.5 million. If your business is earning. P5.” and “90 days overdue or over. divided by 2). you can always take legal action against them if necessary. you will get the figure of P2 million as your total uncollected accounts receivable. you are actually making good profits? If you do. You can now compute the cost to you of the overdue accounts by multiplying that figure by the normal rate of return from your business.56. While this could be financially beneficial. Of course. This gives you a ratio of 0. You can do this either by implementing a stricter credit policy so that your credit sales would decrease in favor of more cash sales. When you multiply this by your average daily sales of P83. You then use this ratio to divide the standard 30 days for a month. Assume.5 million (sales on account) with the average receivable balance of P4. thus forcing you to borrow cash from your relatives and friends often at high interest rates. that your total sales for the month was P3. then your slow-paying customers are actually costing you as much as P40.5 million plus P3. you can age your receivables by breaking down your accounts receivable balance into “current. 2 40 ACCOUNTING 101 FOR SMALL BUSINESSES You need to focus on collecting your small accounts receivables! Normally. Your accounts receivable at the start of the month was. D o you often experience cash shortages and feel that you are losing when. If your normal credit term for your customers is 30 days and your actual average collection period is 54 days. say. You may treat larger accounts receivables that have long been overdue as uncollectible and therefore need to be written o� from the balance. Losses from overstocking can happen when inventory is purchased from the supplier on credit and you are unable to pay on time.5 million and it ended the month at P3.333 (P2. depending on the outcome of your collection e�orts on customers with bad debt accounts. To compute for the receivables turnover. giving you an average collection period of 54 days. or when they project their sales targets too high for a forthcoming holiday season.5 million (P5. When the payment for the loan becomes due.5 million divided by 30 days). you divide the total credit sales of P2. for example.5 million was sales on account. according to your accountant’s report. the risk of loss could sometimes be greater than the potential rewards. then your collection is overdue by 24 days. P2. or by intensifying your collection efforts to lower your accounts receivable balance. you can identify the customers with whom your business has the biggest exposure. you may be overstocking your merchandise inventory for an extraordinary length of time. ■ chapter 10 credit sales with average receivable balance.chapter 9 percent per month on your investment.000 a month! You can manage your cash flow better by shortening your average collection period. and that out of that amount. say.5 million. To have a stronger focus on collection.” Through this.” “30 days overdue. Many entrepreneurs tend to overbuy inventory to take advantage of quantity discounts especially if the merchandise comes from abroad.” “60 days overdue. you get MANAGING INVENTORY 41 .

you can compute the ordering day by deducting 5 days from the turnover period of 13 days to give you 8 days.29 times. When this cycle goes on and on without your noticing it. the payment terms should be at least equal to or greater than your turnover period. your average inventory would be P87. You can determine your ordering day by deducting the lead time from your turnover period. you are able to sell out your inventory every 13 days. you should identify the factors that affect your inventory demands so you can control and manage them better. it may be good to establish benchmarks by spending some time researching and determining the industry average turnover period. not all of your merchandise would have the same inventory turnover. If you are just starting in the business and you still don’t have any idea of your turnover period. you can order your merchandise every 8th day of the average turnover period. regardless of size of business. By the second quarter. When your actual ratio is benchmarked with that of the industry. When you are intimately familiar with the behavior of your inventory levels. you simply divide P200. you are actually incurring real losses from interest costs and lower gross profits—a situation that could lead to a serious cash flow problem. you need to consider the average turnover period of your products. or P200. This way. Some items move quickly. Because different items are bought by different buyers. doing that could actually be detrimental to your company in terms of lost sales and missed opportunities. When you know your inventory turnaround time. The cost of sales is the cost of the products you sold during the period. For example. What it means is that there should be a system that could enable your company to balance its inventory requirements. If you are underperforming against the industry standard. When we say efficient management. To convert this ratio into turnover days.000.000 and your inventory at the end of the month was P75. You can anticipate changes in product demand ahead of time and at the same time control your costs and manage your cash flows better. you may need to relax your inventory-buying during the first quarter of the following year. If it takes five days for your supplier to deliver after you place your order. MANAGING INVENTORY 43 . With that information in mind. You can then use this as basis for your negotiations with your supplier. since retail sales are expected to be weak right after the Christmas season. you can negotiate with your supplier that you will settle your account a�er 15 days. Ideally. This figure means that you sold more than twice your average inventory during the month. In managing inventory. you can manage the lead time of merchandise delivery. you have the advantage of managing your inventory level more efficiently. Different industries have different turnover periods. This figure suggests that on the average. the industry average turnover period is also a good perfor- Use your turnover period to work your terms with your supplier You can also use the turnover period as your basis for determining terms with your supplier.29 to give you the average turnaround time. To compute for the inventory turnover. you can have a rough idea of how to negotiate your terms so you can properly control and manage your inventory level. For example. it doesn’t mean that inventory must be kept at low levels at all times. you can use the proceeds from your sales for some other purpose. though. a�er you dispose of all of your inventories in 13 days. Instead. which is 13 days.000 and that your cost was about 40 percent of it. In this scenario. There are situations when the payment term is less than the average turnover period. needs to understand the importance of efficient inventory management. Depending on the industry where you belong. others move only after some time. To begin with. you may need to consider reducing your inventory level. you 42 ACCOUNTING 101 FOR SMALL BUSINESSES may need to start building your inventory in anticipation of the summer season. If the balance of your inventory at the start of the month was P100.000 by P87. In this example. You can compute your inventory turnover by dividing your cost of sales by the average inventory.chapter 10 mance measure. You can do this by eliminating slow-moving products and obsolete items or by simply increasing your sales. assume that your sales for the month was P500. which gives you 2. Indeed. you simply divide 30 days by 2.500. Under this example. creating an efficient inventory system is the ultimate key to your business success.000. demand for inventory is affected by seasonal factors. the average inventory is the average of the beginning inventory and the ending inventory. SO HOW DO YOU MANAGE YOUR INVENTORY BETTER? Every entrepreneur. you need not shell out cash to purchase the inventory.500. you can receive the new purchases at a time when you expect your old inventory to be sold out. ■ so pressured to raise cash that you are forced to cut your selling price just so you can get rid of your inventories.

to encourage you to pay early rather than on the due date. if the number of days to convert your inventory to cash is rising to 18 days from 12 days.000 and that during the month. assume that your accounts payable at the start of the month was P150. This will give you the average of 15 days. you can now check how many days it takes you to sell your inventory and collect all your receivables. you may need to negotiate your credit terms with your suppliers. For example. In gener- When business is slow. It is thus important that you manage your payables to the best interest of both you and your suppliers. you found out that the balance of your accounts payable by month’s end was P100. this way. The cause of the problem may be poor accounts payable management. Ideally.0. let us say you can convert all your inventories into cash in 12 days. therefore.000. but what they don’t realize is that they are losing the opportunity to earn extra interest income from their cash. To get the number of days payable outstanding. 2 percent if you pay within 10 days for an account payable due in 30 days. giving you a ratio of 2. there are entrepreneurs who pay their suppliers too late and end up being slapped with penalties and charges. After one month of operation.000 by the average accounts payable of P125. you can determine your days payable outstanding by first computing your payable turnover. What this means is that on the average. There are some business owners who pay their payables too early simply because they have so much cash in the bank. This would mean that on the 12th day. perhaps you always feel that you are always short of cash every 44 ACCOUNTING 101 FOR SMALL BUSINESSES time your suppliers come knocking on your door. the total number of days of inventory and receivables should not exceed your days payable outstanding. you would already have the available cash to pay your suppliers and enjoy three more days before your accounts payable becomes due.000. On the other hand. From the same example. To compute for the payable turnover. MANAGING PAYABLES 45 . Sometimes. it takes about 15 days for you to pay your suppliers.chapter You can manage your accounts payable better by stretching out the payment terms as long as possible without damaging your credit standing with your suppliers. As a general guide. for instance by having the term extended by at least three more days up to 18 days to protect your cash position H ave you ever wondered why you sometimes experience cash shortages even if your business is booming? No matter how much money your business generates. suppliers may offer you a trade discount of.000. When managing cash flows. you may consider stretching out your credit terms with suppliers. divide 30 days by the ratio 2. stretch out your credit terms with suppliers If business is slowing down and you are finding it di�cult to unload your inventory and to collect from your customers. With this information on hand. you should remember that timing your accounts payable payments is as crucial as collecting your accounts receivables. In this example. you made total merchandise purchases of P250. say. you need to divide your total purchases of P250. you would receive all cash collections just in time when you are about to pay your suppliers.0x. This ratio simply tells you that you are paying for your purchases twice a month. You can then take advantage of this by depositing the cash in an interestbearing bank account.

so it is wise to take advantage of the discount.9 percent. You then should compare this to the prevailing borrowing rate from the bank.chapter 11 al. ■ ad 5 (ibc) 46 ACCOUNTING 101 FOR SMALL BUSINESSES 47 . How would you know if it is good or not? You can do this by computing the effective interest cost on the assumption that you are going to borrow the money to pay your account in 30 days. It will also be helpful if you can put a monitoring system where you can sort all accounts payable that will soon be due. Using the above formula. If you have negotiated your credit terms to 60 days. lower than the prevailing bank rate of 16 percent. you will know just how much cash you will need to prepare to pay your suppliers on time. In this case. But there are times when trade discounts are not favorable. The formula for effective annualized interest cost is EAI = (discount / 100 percent – discount) x (365 / payment period – discount period). trade discounts are good because it allows you to take advantage of it to lower your purchase costs. we will find that the effective annualized interest cost is 37 percent as compared to only 16 percent. this way. you can afford not to take the 2 percent discount because it is cheaper to stretch out your payment. It is perfectly all right for you to control the terms of accounts payable so they are to your advantage. your effective interest cost would be 14. Suppose the prevailing borrowing rate is 16 percent per annum and you are offered a 2 percent discount if you pay in 10 days an account that is otherwise payable in 30 days.

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